Accountancy Chapter 4 – Dissolution of Partnership Firm

Accountancy Chapter 4 – Dissolution of Partnership Firm

Accountancy Chapter 4 – Dissolution of Partnership Firm

1. Dissolution of Partnership vs. Dissolution of a Firm

• Dissolution of Partnership:
  • This happens when the relationship between existing partners changes but the business continues. For example, if a partner is admitted, retires, or dies, the partnership is reconstituted, but the business does not end.
  • No formal winding-up process is required. The firm can continue under the same name, but with new terms.
  • The key change is in the economic relationship between the partners, who may agree on a new profit-sharing ratio or revise other terms of their partnership.

• Dissolution of a Firm:
  • The dissolution of a firm is the complete termination of the partnership. The business ceases to operate.
  • All the assets of the firm are sold, and liabilities are paid off. The remaining balance is distributed among the partners in their agreed profit-sharing ratio.
  • After dissolution, no business activities continue other than those related to closing the firm, such as settling claims, selling assets, and paying liabilities.
  • According to Section 39 of the Indian Partnership Act, 1932, dissolution of the firm brings an end to its existence.

2. Modes of Dissolution

Dissolution of a partnership firm can occur in several ways:

• Dissolution by Agreement:
  • The partners may agree mutually to dissolve the firm. This can happen through: Consent of all the partners.
  • A pre-existing contract among the partners, which specifies conditions under which the firm will be dissolved.

• Compulsory Dissolution:
  • This type of dissolution occurs when:
    • All the partners or all except one become insolvent, making them incapable of entering into contracts.
    • The business becomes illegal due to a change in law or some event, such as a war where a partner becomes an alien enemy.

• Dissolution on the Happening of Certain Events: A firm may be dissolved due to:
  • Expiry of the fixed term for which the partnership was formed.
  • Completion of the specific venture for which the partnership was created.
  • The death or insolvency of a partner.

• Dissolution by Notice:
  • In case of a “partnership at will,” any partner can dissolve the firm by giving notice of their intention to the other partners. This notice must be in writing.

• Dissolution by Court:
  • A court may order the dissolution of a firm under the following conditions:
    • A partner becomes insane or permanently incapable of performing their duties.
    • A partner is found guilty of misconduct, which negatively impacts the firm’s business.
    • A partner persistently breaches the terms of the partnership agreement.
    • A partner transfers their interest in the firm to a third party without the consent of the other partners.
    • The business can only be carried on at a loss.
    • The court finds it “just and equitable” to dissolve the firm.

3. Settlement of Accounts Upon Dissolution

When a firm dissolves, the partnership ceases business operations, and all accounts must be settled as per Section 48 of the Partnership Act, 1932. The steps involved are:

(a) Treatment of Losses

Losses, including deficiencies of capital, are to be dealt with in the following manner:

1. First, they are covered from profits of the firm, if available.
2. Next, any remaining losses are covered from the capital accounts of the partners.
3. If there is still a shortfall, the partners must contribute personally in their profit-sharing ratio.

(b) Application of Assets

After the assets have been realized (sold or converted into cash), the proceeds are applied in the following order:

1. Paying debts to third-party creditors (outside liabilities like creditors, loans).
2. Repaying any loans or advances made by partners to the firm (this does not include capital contributions but loans made by partners).
3. Repayment of partners’ capital contributions.
4. Distributing any surplus to the partners in their agreed profit-sharing ratio.

4. Private Debts and Firm’s Debts

If both firm debts and personal debts of partners coexist, the following rules apply under Section 49 of the Partnership Act:

• Firm’s property is first used to pay off the firm’s debts. Any surplus left is distributed among partners and may be used to settle their private debts.
• Private property of partners is used to pay their personal debts. Any surplus left can be used to meet the firm’s debts if the firm’s assets are insufficient.

5. Insolvency of a Partner (Garner vs. Murray Rule)

• If a partner is unable to contribute their share to meet firm liabilities due to insolvency, this is treated as a loss for the firm.

The remaining solvent partners are responsible for this loss, which they bear in proportion to their capital contributions (not their profit-sharing ratio) as of the dissolution date.

6. Preparation of Realisation Account

The Realisation Account is a special account prepared to record the following:

• Transfer of all firm’s assets and liabilities to the Realisation Account at their book value.
• Sale of assets and realization of proceeds.
• Payment of liabilities from the proceeds.
• Any expenses of dissolution (realization expenses).
• Distribution of profit or loss from realization among the partners.

7. Realisation Expenses

• If the firm incurs the expenses: Realisation A/c is debited, and Bank A/c is credited.
• If a partner pays the expenses: Realisation A/c is debited, and that partner’s Capital A/c is credited.
• If a partner agrees to bear the expenses for a fixed remuneration:
  • The partner’s Capital A/c is credited for the agreed amount of remuneration.
  • If the actual expenses exceed the agreed remuneration, the firm bears the additional expenses.

8. Unrecorded Assets and Liabilities

• Unrecorded assets (those not appearing in the balance sheet) are credited to the Realisation Account when realized.
• Unrecorded liabilities are debited to the Realisation Account when paid.

9. Settlement of Partners’ Accounts

• After settling external liabilities, partners’ loans are paid off.
• Any remaining capital is then distributed to the partners.
• If a partner’s capital account shows a debit balance, that partner must contribute cash to clear the account.

Final Settlement: Once the Realisation Account is closed and all liabilities are settled, the final balance in the partners’ capital accounts is either paid to the partners or they contribute in case of a shortfall.

10. Closure of Accounts

• Books of accounts are closed after all liabilities have been paid and partners’ accounts have been settled.
• The firm no longer exists, and no business transactions occur beyond the closing process.